How Investing in Bonds Protects You From the Risks of the Stock Market
This article was reviewed by Robin Hartill, CFP®.
Investment conversations typically focus on stocks, but any financial adviser will tell you a portfolio is strongest when it’s diversified. That means you don’t want to only invest in stocks. A healthy portfolio has bonds as well.
Bonds are inherently low-risk investment options, but they also don’t have the high potential earnings of stocks. Instead, they provide balance against high-risk (but high-yield) stocks.
What Is a Bond?
When you need to buy something you don’t have all the money for, you take out a loan. Sometimes, corporations and federal and local governments need to take out loans, so they issue bonds.
They promise to pay back lenders (that’s you!) in a set amount of years on the bond’s maturity date, or when the bond ends. A corporation or government body can issue bonds for anything from funding research for a new product to raising money to build new infrastructure.
The issuer of the bond also makes interest payments along the way, typically twice a year. These are known as coupon payments.
One exception: zero-coupon bonds, which don’t pay interest until the maturity date. Some people choose them as investments for children with the idea that the bond will mature in time for college tuition.
3 Types of Bonds Explained
There are three main types of bonds to know about as a beginning investor: municipal bonds, treasury bonds and corporate bonds.
Also called T-bonds, Treasury bonds are issued by Uncle Sam. They are entirely backed by the federal government, and they’re issued at maturities of 10 to 30 years. The interest you earn is tax-free at the state and local levels, but you’ll still pay federal taxes on it.
The biggest draw of a treasury bond? It’s essentially risk-free unless the U.S. government goes under. And if that happens, we probably have bigger things to worry about.
Treasury bonds typically yield similar interest rates as comparable municipal bonds.
Municipal bonds are issued by cities, states and other local municipalities to fund projects like building new roads or renovating parks.
Interest on municipal bonds is exempt from federal taxes. When you purchase municipal bonds in your own state, the interest is often exempt from state and local taxes, as well. An added win: As a citizen, you enjoy the rewards of your investment by using the services of your city and state every day.
There are two types of municipal bonds:
- General obligation bonds, which are used to fund public works. They’re backed by the full faith, credit and taxing power of the issuer. That means that, if necessary, the issuer will raise taxes to repay bondholders.
- Revenue bonds, which are backed by a specific project, like a hospital, toll road or stadium. They aren’t backed by the full faith and credit of the issuer, which makes them riskier. They pay higher interest rates than general obligation bonds because of the higher risk.
Corporate bonds are the riskiest of the three types of bonds.
Unlike the previous two categories of bonds, corporate bonds are issued by companies. Purchasing a bond from a company is different from purchasing stock, which gives you partial ownership in that company, whereas with corporate bonds, you’re lending a company funds.
They come with credit risk, which means that if the corporation can’t afford to make its debt payments, bondholders may not get their interest and principal payments. If the corporation files for bankruptcy, secured creditors get paid in full before bondholders recoup their investments.
The biggest draw of corporate bonds is that they pay out the highest interest rate of the three main categories of bonds.
4 Benefits of Investing in Bonds
Investing in bonds yields several key benefits:
1. They Are Generally Safe Investments
All investments carry some risk. There’s virtually no risk of default with Treasurys, but because the risk is low, so are the interest payments. You run the risk that they won’t keep up with inflation. You could also miss out on other investment opportunities that yield better returns.
It is very unlikely that the issuer of a municipal or high-quality corporate bond will default — but if they do, you lose out on that investment. (Default is a greater possibility with junk bonds, which are the riskiest corporate bonds. They pay a high yield to compensate investors for their increased risk.)
Because the stock market can be so volatile, bonds can balance out the high risk of stock investments. This is especially important as investors near retirement age and can’t afford as much risk. Many financial planners recommend that investors gradually shift more of their portfolio from stocks to bonds as they get older.
2. They Provide Fixed Income
Bonds offer some regularity to your income stream, because you can typically count on the coupon payments twice a year. This makes budgeting somewhat easier. Because bonds offer fixed income, they’re a popular investment choice for retirees.
3. They Give You the Chance to Give Back
Municipal bonds in particular are appealing because they give you a sense of bettering your own community. The same can be said of Treasury bonds, just on a larger scale.
Even corporate bonds can instill a sense of investing purpose if you are passionate about a specific product or brand.
4. They’re Easy to Manage
If you don’t use a financial adviser, playing the stock market can be tough. When do you buy? When do you sell? And how do you do those things?
With bonds, you can earn income just by buying once and letting the bonds mature — although some investors do sell their bonds before the maturity date at a profit or loss.
3 Drawbacks to Investing in Bonds
Bonds are not without drawbacks. Here are just a few:
1. Bonds Aren’t High Earners for Your Portfolio
Bonds offer stability for your portfolio and balance out high-risk stocks. However, the lower the risk, the lower the reward. Compared to stocks, bond growth is minimal.
Large stocks have had average annual returns of 10% since 1926, while large government bonds earned average annual returns of 5% to 6% over the same period, CNN Money reports.
2. There Is Still Risk Involved
Bonds, however, carry some risk, though it is small compared with that of stocks. A bond issuer can potentially default on the bonds, meaning you might not earn interest, might lose your principal investment or both.
Another type of risk with bonds is called interest rate risk. When interest rates rise, bond prices — and thus the value of your bonds — could decrease because investors can earn higher interest rates elsewhere. When interest rates drop, your bonds could be easier to sell if they’re paying interest rates that are higher than the current market rate.
Inflation is also a risk: If the interest you’re earning from a bond doesn’t keep up with inflation, you’re essentially losing money, because the value of your investment is going down.
3. Your Funds Are Tied up
When you purchase bonds, you generally need to be committed to investing for the long haul. With savings accounts, you can access your money when you need it, and stocks can be bought and traded as you see fit. Bonds, however, require you to wait until they mature to get the full rewards of the investment.
How to Invest in Bonds
Unlike stocks, which are traded on the public exchange, bonds must be purchased from brokers — unless you are interested in government bonds, which you buy from the United States directly. Knowing if you are getting a fair interest rate can be challenging, but you can check recent rates via the Financial Industry Regulation Authority.
You can use bond ratings from Moody’s, Fitch and Standard & Poor’s to assess the strength of a bond. In general, you should concern yourself with a bond’s credit quality, maturity and yield.
Individual Bonds vs. Bond Funds
How much money you can invest in bonds depends on several factors. Individual bonds issued by the U.S. Treasury, for example, are sold in $1,000 increments. Municipal and corporate bonds are usually sold at the $10,000 level or higher, sometimes even reaching $100,000.
Bond mutual funds and ETFs are alternatives to purchasing individual bonds. They represent a range of investments all poured into a single bucket. If one of the bonds defaults in that fund, you still have the other bonds to protect your investment. You’ll have to go through a mutual fund company to purchase a bond mutual fund, but bond ETFs are traded on stock exchanges.
However, when you purchase individual bonds, you will need to thoroughly research the issuers before putting your faith in them.
If you are serious about investing for your future, bonds will typically play an important role in your portfolio — but not the leading role. To figure out the right balance for your portfolio, talking with a financial adviser is a good place to start.
Timothy Moore is a market research editor and freelance writer covering topics on personal finance, careers, education, travel, pet care and the automotive industry. His work has been featured on Debt.com, Ladders, Glassdoor and The News Wheel.